Tuesday, July 22, 2014

Should Startups Have Boards of Directors?

All corporations are required to have a board of directors by law. LLCs are not. However, an LLC can be structured so as to have a board of managers (some even refer to managers as directors). At formation, founders become the sole directors of their startup corporation. They alone are responsible for the long-term vision and the daily management of their company. Creating a real board of directors may be viewed as giving up control. However, at some point the board composition is likely to change. The question is: do all startups need to have a board of directors? And if yes, then at what time should they create one?

In my opinion, not every company needs to have a board (or, if it is a corporation, then a board that has outside members). If a founder prefers to closely manage the affairs of his or her company, then having a board of advisors may be sufficient. A board of advisors is an informal body that usually consists of industry experts. A CEO may consult any of the advisors throughout the year on an informal basis, through a series of meetings or conversations, but ultimately, all decisions are the CEO’s.

A start-up may, however, be asked to create a board regardless of how the founders feel about it. This typically happens if the startup is about to receive an investment and the investor wants a seat on the board. This is not an unusual request. So, if a board of directors were to be created, what would the ideal board look like?

An ideal board would be (mostly) independent and active. Its members would have a lot of experience and advice to share with the founders. A perfect board would have a financial expert, a marketing expert, persons who have previous startup experience, connections in the industry, and connections with potential investors. The perfect board would be there to help, not judge. The majority of its members would be outsiders, and would not be influenced by other motives (such as, for example, the need to make a successful exit in 7-10 years).

A startup does not need to have a large board. Typically, 5-7 members is perfect. Personalities of directors are also important. The board has to function well and efficiently as a unit, and get along well with the management. A board should meet monthly (or quarterly) and discuss the long-term strategy of the company. The day-to-day operations are left to the management. The board reviews the management’s performance and determines their bonuses on a yearly basis. This means that, if the board is not satisfied with the performance of any of the managers (including the founders), it can fire them. Unfortunately, this does occasionally happen. It recently happened to one of my clients, who originally created a board comprised of industry experts and then the board voted to fire him. Of course, this created a ton of emotions and negative feelings. All I can say is that founders should ensure that their vesting accelerates if they are fired for “no cause” or are asked to leave for a “good reason.”

The board members do not receive much compensation. This is not why they serve on the board. They typically get reimbursed for expenses incurred in attending board meetings and are given restricted stock or stock options.

Directors in a corporation owe fiduciary duties to the corporation and its shareholders. These are duties of care and loyalty. I previously wrote about them, and the business judgment rule, here and here. The corporation should ensure that, when creating the board, its articles of incorporation are amended to limit directors’ liability to the maximum extent allowed by law. Also, the corporation should consider getting a D&O insurance (although it can be expensive and cost prohibitive for a startup).

In conclusion, I would note that creating a helpful, independent and active board can certainly bring your company to the next level. This is the necessary step in transitioning from a startup to a “grown up” corporation.  Last, but not least, read this book "Startup Boards: Getting the Most of Your Board of Directors" by Brad Feld.  He really knows what he is talking about.  

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Saturday, July 19, 2014

The SEC Will Likely Update its Definition of “Accredited Investors” Very Soon

Most of the startup capital comes from accredited investors through investments made in reliance upon Rule 506 of Regulation D.  According to a study by the University of New Hampshire’s Center for Venture Research, in 2013, almost 71,000 benefited from $24.8 million in investments made by accredited investors.

So, who are these “accredited investors”? The definition of “accredited investors” is found in Rule 501 of Regulation D and includes the following individuals:

1. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or

2. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Section 413(b)(2)(A) of the Dodd-Frank Act requires the SEC to review the definition as it relates to the natural persons every four years to determine whether "it should be modified for the protection of investors, in the public interest and in light of the economy.” Now is the time for the SEC to do so. The last review of the “accredited investor” definition by the SEC was done in July 2010.  At that time, the definition was amended to exclude the value of a primary residence from the calculation of investor’s net worth.

In a letter to Representative Scott Garrett in November 2013, the SEC Chair Mary Jo White described potential changes to the accredited investor definition and factors that the SEC is considering.  It indicates that this time the changes to the definition may go beyond merely adjusting the net worth minimum requirements for inflation.

In particular, Ms. White’s letter states that the SEC is examining:
  • "whether the existing net worth and income tests are appropriate measures that should continue to be used (presumably this also includes consideration of whether and how the net worth and income thresholds could or should be adjusted);
  • whether financial professionals, such as registered investment advisers, consultants, brokers, traders, portfolio managers, analysts, compliance staff, legal counsel, and regulators should be considered accredited investors without regard to net worth;
  • whether individuals with certain educational backgrounds focused on business, economics, and finance should be considered accredited investors without regard to net worth;
  • whether an expanded pool of accredited investors would help provide liquidity in private placement investments and thereby reduce the risk profile of those investments;
  • whether reliance on a qualified broker or registered investment adviser should enable ordinary investors to participate in private placements; and
  • whether reducing the pool of accredited investors would harm U.S. GDP."
If the SEC were merely to adjust the amounts for inflation, according to the Angel Capital Association press release, the “inflation-based adjustments would increase the net worth standard to about $2.5 million and the annual income to $450,000."  This increase would “eliminate about 60 percent of current accredited investors.” Also, the Association said that such inflation-based adjustments would reduce its membership by 25%.

However, based on the November letter, it appears that the SEC is undertaking a more comprehensive review of the definition than just adjusting it for inflation. In my opinion, simply relying on net worth or income amounts is not enough to determine the investors' suitability for high-risk investments into startups.  I have come across many individuals who, although they satisfy the net worth or the income test of the current accredited investor definition, entirely lack financial sophistication and can be easily talked into investing into the most unbelievable schemes.   On the other hand, I have met financial industry professionals, who are quite able to "fend for themselves," although technically they do not satisfy the income or net worth tests.  

I also believe that it is important to keep a fairly large pool of accredited investors, because they help fuel the growth of our economy.  While the crowdfunding rules are still pending, it is essential to keep or even increase the angel community in order to provide continued support to the startups and entrepreneurs.  After all, today's startups are tomorrow's Fortune 500 companies.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.